Posted
by
Soulskill
on Saturday April 28, 2012 @10:35AM
from the can-we-blame-fermat-for-this dept.

New submitter jools33 writes "The BBC has a fascinating story about how a mathematical formula revolutionized the world of finance — and ultimately could have been responsible for its downfall. The Black-Scholes mathematical model, introduced in the '70s, opened up the world of options, futures, and derivatives trading in a way that nothing before or since has accomplished. Its phenomenal success and widespread adoption lead to Myron Scholes winning a Nobel prize in economics. Yet the widespread adoption of the model may have been responsible for the financial crisis of the past few years. It's interesting to ponder how algorithms and formulas that we work on today could fundamentally influence humanity's future."

It's worth pointing out that the "Nobel Prize in Economics" was not one of the original six prizes founded by Alfred Nobel. It is a separate award, which was invented by the Swedish central bank in 1968. Although it is presented along with the Nobel prizes, it is not technically a Nobel itself.

FRAUD ALERT: It was not a mathematical model that caused the
problem. It was fraud. Financial organizations convinced investors that they
had a "mathematical model" so that they could steal. The theft was
ENTIRELY deliberate, as is described in detail in the 1997 book F.I.A.S.C.O.: Blood in the Water on Wall Street [npr.org], by Frank Partnoy.
Somehow the issues were kept quiet for 11 more years until the theft could be completed
in the 2008 financial crash. Traders called their work "ripping the
client's face off" [lbo-news.com].

Nothing has been done to reform the extremely
corrupt financial system in the United States. No one in the SEC, U.S.
Securities and Exchange Commission, the government organization that is
supposed to police financial fraud, was prosecuted, even though the agency
knew of the abuses. See the February 17, 2009 show Frontline: Inside the Meltdown. [pbs.org]

Even though the U.S. dollar is experiencing rampant
inflation in 2012, U.S. banks give less than 1% interest on savings. Those who would like to
invest can't because the system is so corrupt it cannot be trusted. Corporations
hold unprecedented amounts of cash. See, for example, the October 7, 2010 Washington
Post article, U.S. companies buy back stock in droves as they hold record levels of cash. [washingtonpost.com]

F.I.A.S.C.O. stands for "Fixed Income Annual Sporting Clays
Outing" (See page 100 of the 2009 edition.), held at a shooting range
called "Sandanona, a club in upstate New York" (Page 97 of the 2009
edition). Traders would go there to shoot guns. The idea was to encourage
their taste for violence so that they would be even more financially violent
toward the customer.

Perhaps the April 27, 2012 BBC article, Black-Scholes: The maths formula linked to the financial crash [bbc.co.uk] referenced in this Slashdot story was influenced by public relations agencies trying to get people to believe that the crash was caused by errors in mathematical thinking, and not by fraud, so that the financial industry can continue stealing.

It would be helpful if Slashdot editors signed a statement about each story saying that they know of no conflict of interest, and no one was paid to run the story.

It amazes me that some people can see conspiracies everywhere. I've not posted a story before on slashdot - but it seems to me that you are seeing conspiracies where there are none. I have no relationship to the bbc - I don't live in Britain - and I have no interest in finance organizations - as a software engineer I design and write code for a living (and not for financial institutions). This article interested me from the perspective - that making false assumptions - and misuse of a formula or algorithm - can have unforeseen consequences beyond the original authors wildest dreams - which is what I find fascinating and the sole reason why I posted the story. I can guarantee you that I will not receive a single kronor (as I live in Sweden) for this article. I wonder how you think Slashdot editors are going to police the articles that get posted as you suggest. To my mind that kind of heavy editorial censorship would also be heavily criticised.

"DerivativesCharlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system."

From page 14:

"I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive "earnings" (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham."

Warren Buffett, the world's most famous investor, published that in 2003. It was widely reported. No one can say the fraud was unknown, or that the present severe economic problems are due to a faulty mathematical formula.

It's not fraud as long as the liabilities created by the derivatives are reported on the balance sheet. The liabilities may be difficult to quantify, but as long as they're disclosed the diligent investor can decide for themselves how they're going to respond. What Buffet was saying was that it was very difficult, in his opinion, to estimate the risks in these complex derivatives transactions and Warren Buffet is well known for refusing to invest in things which he either doesn't understand or cannot reliably quantify (his avoidance of high tech investments are another example of this). Just because an investment is high risk or because foolish investors don't or cannot understand the risks that they're really taking doesn't make it fraud. This is an important distinction that's often lost upon the Occupy people and those who decry "preditory lending" or "cutthroat capitalism". Personally, I agree with Buffet and don't invest in futures or derivatives because I don't understand them. Indeed, I suspect that few people, even among professional traders, actually do. So when someone tells me that they fully understand all of the risks associated with their derivatives trade I know that they're either a savant or a liar. However, just because an investment is complex and risky (the two often go hand in glove) doesn't automatically make it fraudulent. As with most things in life, if it sounds too good to be true, it probably is.

Or, with a different twisted view, derivatives were thought to be helpful by those who have done an otherwise fantastic job of dealing with the complex nightmare of the finance world. That they turned out to cause a catastrophe is more about our collective failure to understand the problem and heed the advice of the few against the resounding successes the stock market gave all of us. We were awash in wealth from the lowly home-owner with a mortgage only sustained by constant economic grow to the financier receiving another multi-million dollar bonus. Only those who had no need for continued success could view the situation with cold logic and real understanding, but they were telling us something we didn't want to hear.

Selling neg-am mortgages to developers that have all their permits ready to go for construction is providing a service.

The fact that the statute of limitations on TILA(truth in lending act) fraud is three years tollable to four years and the neg am mortgages blowing up on the homeowner in 4.5 years on average is the result of bipartisan support for the fraud.

The only fair way to clean up the foreclosure mess is to allow bankruptcy judges to on

Does it enter into it that the sales people targeted people likely to have a lack of financial knowledge?

I know of no DINK (dual income no kids) households that entered into neg-am loans. I know of lots of single women, and people that were have minimal English skills (enough to get by, but not enough to understand a legal contract, whether because of lack of education, or English being a second language that they had not yet mastered.)

The real idiots are the investment managers that bought the Asset Back Securities. Those people should be barred from managing anyone else's finances under any situation, and probably have their own assets put in a receivership for their own protection, a la Britney Spears.

Reforming the bankruptcy laws so people can keep their primary residence requires repealing existing law, not creating more law.

This is a false statement, unless you consider low single digits to be rampant.

The CPI and BPP [mit.edu] bear this out. The CPI is done by the government, so if there was enough of a conspiracy, they could conspire to keep the official numbers down. I don't think any alleged conspiracy could reach the BPP.

Food, +4.8% -- Food Price Outlook, 2012 [usda.gov]
Quote: "The food-at-home Consumer Price Index (CPI), in turn, increased more than expectedâ"4.8 percent in 2011â"which means that food price inflation was not as strong as in 2008 when it increased 6.4 percent over 2007."

Medical treatment, +8.5% -- Medical cost trends for 2012 [pwc.com]
"This year's report from PwC's Health Research Institute finds that the medical cost trend is expected to increase from 8% in 2011 to 8.5% in 2012."

After the 2008 crash, there was no deflation at all, which is what you would expect after a huge bubble bursts. The Fed pumped so much money into the system, the result was continued inflation rather than the deflation. And TARP was basically an extortion, which taxpayers will never get back in full. But who got this huge injection of printed money? The 1%. Basically, money was stolen from the 99%, via inflation, to further enrich the 1%. And take a look at the MF Global scandal, where $1.6B of customer mon

Fraud is a big problem, but not the worst problem. I've grown concerned that we're all engaged in mass delusion. We think the world works a particular way, but we may be wrong. We can produce what seems to be supporting evidence. I am referring to a much more fundamental idea of finance: the formulas for rates. They're neat and simple, and wrong. Implicit in compound interest is exponential growth. The universe doesn't support exponential growth.

Historically, depending on who you talk to, the stock market has averaged an annual rate of return of 7% or 10% or even more. But that record is only about 100 years long. Can the stock market keep up 7% growth for another 100 years? If it can, how about 1000 years?

Shortly after acquiring a maths degree I was interviewed for a job in a certain major investment bank, to deal with their "really complex" deals. In preparation, I was given a bundle of notes on the maths behind trading, including the Black-Scholes 'formula'. It was quite interesting, essentially being an application of Brownian motion [wikipedia.org], with some fancy economic terms involved. So basically, the whole financial model is based on the fact that they have absolutely no idea whether stuff will get better or worse, so just add layer and layer of complexity to try to even it all out.

Of course, that's only half the problem with the financial industries. I then actually went to the interview, and it turned out the job seemed to involve simply keeping an eye on spreadsheets to see what they're doing, rather than any actual maths. The person interviewing me (who would have been my boss's boss) clearly had no clue about any serious maths, or the differential equations underpinning his entire industry, but had a firm handshake and sounded confident.

Needless to say I didn't get the job, nor want it. But it doesn't surprise me that there was a massive financial crisis - the whole sector seems little more than a confidence scam on the rest of society. "Give us your money and we'll make you more money."

So the book presents a hypothetical derivatives salesman (who doesn't exist), says he used to read Time but now he reads Guns and Ammo, and offers that it's no coincidence. Of course it's no coincidence; the same author made it all up! I do think there's lots wrong with Wall Street, but your book sounds like a bunch of sensationalist junk, frankly.

This is a common refrain. Yet economics is a hard, hard, science - why else do we understand it so badly? Newtons invented calculus and a few mere centuries later we built atom bombs and mapped out the history of the universe nanoseconds after its birth. Yet for all the history of human commerce, we barely understand a subject that affects all of us, every single day.

The complexity of the system largel invalidates the scientific method's assumptions, thus greatly limiting the applicability of the reasoning. That is why, for sufficiently complex systems such as economics, psychology, sociology, or theology, other assumptions must be used. That doesn't emean that those who study such things are irrational. It just means that the tools and judgement of results must be different. Alchemy was once also at such a stage-- but today it has advanced to a science(except at the University of Utah).

You forgot climatology and cosmology. Or are the objects of these "sciences" not sufficiently complex?

They don't really alter their fundamental behavior as a consequence of you publishing your theory. The problem with the human sciences is that humans read the discoveries and change what they're doing because of them. By comparison, large scale physical systems (the climate, the cosmos) don't give a fig what we think about them; even those changes that we can effect will not fundamentally alter the science itself.

I think we need to be more specific. It's not the complexity of the system (or else there is no interesting science), it's the inability to test hypotheses that makes economics a dubious science. But the same is true for many other disciplines (climate science, astrophysics, social sciences, etc). For me, the difference is that economics is mostly the science of human interaction, which much like biology turns political before most people have even heard the science. It is unfortunate to see it turn political so quickly on Slashdot, the place where science should always be heard first.

I may agree that "inability to test hypotheses" is part of the problem, but there a wider issue here: a "political" inability to assess if the price of complexity is less than the advantage it does.
There's an example here pertaining the US. The Glass-Steagall Act [wikipedia.org], promulgated after the 1929 financial crisis, had a fundamental assumption, which can be broadly stated like this: "while financial markets are essential to an efficient allocation of financial resources, it must be kept by law separated fromthe mechanism of transmission of monetary policy to the real economy. It ensues that no economic player must be allowed to participate in both systems, either as principal or agent". Fast forward to 1987, and the the president of the federal reserve, Alan Greenspan, urges a repeal of the law. what did he know that was unknown in the thirties? why, nothing: he was only convinced that advances in law, mathematics, economy had rendered the safeguards obsolete. Guess what? future contracts were known in Roman times, and the first financial contract I've seen printed is in cuneiform on a tablet, circa 2.000 B.C; the only significant innovations in banking since the Hammurabi code had been the supervision of the banking system, including the obligation on the banks to actually have some equity money on the balance sheet, and.... the Glass Steagall act.

coming back to the topic, the impact of the Black and Scholes formula was not only on the ability to "price" an option, assessing an hypotetical fair value, but on the fact that it provided a toll for big financial houses to "hedge" [wikipedia.org] their exposure dynamically, therein being able to actively propose derivative trades to clients instead of matching opposite client's views. The market expanded greatly, but so did the dependence of the assumptions of the models being right: continuous market access, infinite liquidity, both on the long and the short side. etc.

Lo and behold, everybody and his uncle played derivatives (Enron anyone? an electric utility, a business slightly less boring than watching grass grow, going belly up?!?!), and it has been impossible to separate the impact of the disaster on the financial markets and on the real economy. Think about this: when Long term capital [wikipedia.org] went bust, if you were a shopkeeper in Illinois you had a more than 50% chance of not knowing about it, let alone feeling the heat of the aftermath; now shopkeepers tremble at the sight of the Wall Street Journal.

Yeah, here I was thinking it was because banks lent lots of money to people and countries who couldn't afford it, then acted surprised when they didn't get it back again. Not it turns out it was Math all along. Damn you, Math!

Primarily.
However, the real blame doesn't lie with the banks, it lies with governments.
It is lending as you say, but its governments borrowing and lying about their borrowing. The main method, and the sums involved are huge, and they are unfunded pensions liabilities. Take the money up front and spend it. Then rely on future taxpayers to pay the bills. Just like in the US and the subprime mortgages, its easy or no payouts up front, but lots of money flowing in. Then it tips. All back end loaded. Now if

The real problem is that the "solution" - bailing out of the banks by the governments that were the source of the problem, is no real solution. It creates a delay. And while a delay was certainly necessary once they let it become as bad as it became, it will just repeat. A lot of Hedge funds are going to become rich - again.

Solving the problem would take a prolonged crash that lasts - well lasts until the system rebalances. That sounds cute in theory but in practice it means that it must last until the baby boomer retirees (a big portion of them) are dead. It also means Obama and the democrats have chosen very close to the worst moment in the nation's history for their national healthcare. It will be a disaster much sooner than even the worst of the republicans projected. It will become a disaster in the next 3 years.

And nobody can really do anything at this point - well I guess baby boomers could commit suicide in large numbers but... - it's like watching a ship about to crash from the top of it's deck. There's nothing to do but watch. If you're a hedge fund manager you play a few games betting on the ship crashing while the captain assures everyone everything's fine and the ship is unsinkable.

This situation also means the real crash hasn't come yet. It will happen not this year but by the end of next year.

No need to blame the banks. It was a systemic problem that was not created exclusively by the banks (Ratings agencies told them the risk was low), by finance (derivatives are actually an excellent financial tool when used intelligently), by government (government backed credit has been used since time immemorial, some for good some for bad, regarding both intention and result), by salesmen (the micro-economics were sound), by buyers (again with the micro-economics), or by the ratings agencies. I don't hav

It wasn't even just that, it was that they made the mistake of assuming that the higher interest they were getting from the risky loans was pure profit, instead of a hedge against the higher risk. If my portfolio of loans has a 10% chance of not being paid back, I would have to charge at least 10% interest to break even. They did that, but they booked and distributed the profit before the loans started to fail. It was basically a gross profit versus net profit mistake.

Then there was the failure of the CDS market. Companies made investments, then bought insurance policies to hedge their losses on the loans. But when the loans started to fail, the CDS/hedge couldn't be paid back (cough AIG cough) and they were fucked. I think that will eventually come out as being the ultimate failure- too many layers of reinsurance.

Except that it's banks making the decisions, and governments writing rules that allow them to do various things, and create environments that cause problems.

Human greed always contributes. It is both what drives our economy forward, and causes it to run into a wall occasionally. We always want something just out of reach. It gives us something to work for, but it also means that if you overestimate, even by a few percent you can cause a 'bust'. When the people doing this are controlling (not necessarily owning, just controlling) 80% of the countries wealth with a relatively small handful of people you can see where this goes badly.

To use the example given, if there's a 10% chance of loans not being paid back, but for the last 5 years I've only had a 3% default rate rather than 10, either

1.The 10% chance of failure estimate is wrong,2. this is an effect that's longer than 5 years or3. I should be allowed to change how I count the difference. (the lag effect is long enough I should be able to do something else with the money rather than just sit on it for another 5 years sort of thing)

Enter the government, who, by the way, is largely run by people who have money, and as an institution cares very much about investment returns and interest rates, and they look at your problem. The government probably set the 5 year threshold, it may not have any connection to anything that matters, but it seemed like a good number when someone thought it up. It's possible my estimate is wrong, or worse, the government approved estimation technique is wrong, which means everyones estimate is wrong. Lastly, the government will change how that money can be counted, and what I can do with it. This last point is really the most insidious. Politicians will want to write rules that advantage them when they leave government, and that will advantage their investment portfolios. That means going along with changing how risks are counted, or how to handle the difference between calculated and actual risk in a way that will most benefit themselves personally when they leave. Whatever looks like it will help the bottom line the most right now. And that is very bad policy.

After that, the whole situation is exacerbated by other government policies which aren't directly applicable to what we just talked about. Wealth distribution that has become less equal pushes more money into a smaller number of hands, meaning when they make mistakes they take a larger chunk of the economy with them. The government has written rules (about unions, trade, taxes etc.) that significantly impact wealth distribution.

The government also controls the currency supply, and acts as the insurer of last resort, if it feels like it. Currency supply isn't as much of an issue in this recession compared to the great depression (where the gold standard exacerbated the problem for those still on it). The government has mostly managed to avoid a deflationary spiral, although that's about the only good thing you can say, and it's not even that strong a statement. But the insurer of last resort, if it feels like it is a serious problem. When a company (bank or otherwise) starts to spiral out of control, especially with the CDS situation where there was essentially a bank run, how quickly the government moves to insure banks, how much it's willing to insure etc all can determine how bad the crash is.

If this sounds a lot like the great depression, it's because it is. Other than the gold standard issue* basically all of the same principles and problems and theories apply. There are substantial differences in specific, but: massive overburdening debt on consumers and banks, check. Significant wealth inequality, check. "Austrians" (the economic school of thought) claiming too much money supply previously, check. The same group claiming government policies to help were counter productive, check. Excess production capacity, (now largely driven by production in china rather than electrification and motorization) chec

Saying Germany and France control the Euro is misleading since France's influence on the Euro was never equal to Germany's and lately has diminished further. The Eurozone troubles are a classic case of merchantilism. Germany's policies of trade surplus made possible by domestic wage suppression, combined with a single currency, is benefiting within the Eurozone only those at the top of German industry and finance. The resulting disaster was predicted decades ago by Modern Monetary Theorists.

France's economy is big enough it influences the euro both directly and indirectly. What happens to greece is about the same as what happens to north carolina, sure, it can be bad there, but over all it's not that much of a problem. France on the other hand is about 1/5th of the eurozone (compared to germany 1/4), what happens there will significantly alter the value of the euro. Italy is about the same with spain a distant 4th. The 'big 3' of France, Germany and Italy should reasonably define the euro

That's half the problem. The other is that poor mortgages were packaged into CDOs [wikipedia.org]. This in itself was OK, but the unsaleable bottom tranches of the CDOs were then repackaged into new CDOs. These should have been rated as entirely high risk (being a collection of mortgages that, due to the first CDO, were almost guaranteed to fail) but gullible ratings agencies still gave the top tranche a top rating. So investors worldwide were buying crap believing it to be a low risk investment.

These should have been rated as entirely high risk (being a collection of mortgages that, due to the first CDO, were almost guaranteed to fail) but gullible ratings agencies still gave the top tranche a top rating. So investors worldwide were buying crap believing it to be a low risk investment.

The ratings agencies weren't gullible. They were in on it too. They were paid for their ratings by the people asking for the ratings. If they'd done their jobs and rated them poor, those buying the ratings would go elsewhere for them.

The ratings agencies ought to be sort of like Consumer Reports. Instead, they are just another business out to make a quick buck like everyone else. Investors should have seen this coming, but no-one thinks long-term investing anymore. Fundamentals? What are those?

I agree with those above who say it hasn't finished yet. The bailouts just bought the Too Big To Fails some time. They should have been allowed to fail, but politicians couldn't accept that when their cushy jobs were on the line.

It was the greedy preying on the stupid to the detriment of the rest of us. But an unchained wolf will hunt when it sees food, and so will a sociopathic CEO. The blame lies with those who let them run free in the first place by deregulating the financial sector, not on animals following their instincts.

The blame lies with those who let them run free in the first place by deregulating the financial sector, not on animals following their instincts.

The deregulators absolutely deserve blame, but so do the predators here. They aren't animals, they are people who have free will and the ability to make moral decisions and thus they have culpability unlike an actual wolf.

Reality distortion field? I'd have to say it's the rest of us in the distortion fields. We don't have enough information to understand the system, yet many of the people on this topic have decided they know who to blame for the crash. I've come to accept that reality distortion fields are a necessary part of belonging to the human race. The few of us that can get past them are likely to hold power over the rest of us. Using reality to one's advantage is of course the ultimate power.

If I see that you are hungry and I sell you food for a profit, you call that empathy ? Or is it only when my business failed because I didn't calculate my margin properly, that you blame empathy ?

Bankers thought they could make money off people with no money using their clever formula. They were wrong. Some of them maybe thought they were making the world a better place (empathy), but at the end of the day they were in it to make a profit.

The past tense of lead is "led", not "lead". When "lead" is pronounced like "led", it's a metal. This mistake pops up everywhere. Correcting it here won't fix anything, but when someone on the internet is wrong, duty calls.

People do. The downfall was made by people using tools (like that formula) without understanding all that required or implied.

Quite so. A risk evaluation that says "95% of the time you will lose less than X" implies "5% of the time you will lose a more than X".With the stinger being that it says nothing of the range and distribution of values of "more than X".

You're so sure they didn't understand what they were doing? Maybe they didn't care. None of them returned their commissions on all the trades and phony "profits" they took out of the system, and practically nobody went to jail. They won. Furthermore nothing much has changed. It will happen again.

Well who really is to blame? The banks for taking advantage of vehicles that were seen as revolutionary and safe, hedge funds for generating extreme demand for said vehicles despite their safety going beyond common sense once the market grew, the credit reporting companies that kept the insurers credit ratings despite being undercapitalized to fulfill the insured debt obligations, or the government administration that saw the rise of the derivatives market amd subsequent housing bubble but chose to not inte

You are both right. The fund managers and their pet quants did not understand the whole process and the effects of their actions, all they knew was they were 'printing money' out of thin air every day. Cannot say they were not warned by many, including the father of quantitative analysis; the late, great Mr. Mandelbrot [goodreads.com]. Yeah, the fractal guy. Taleb [wikipedia.org] was also an ardent 'wet blanket'. Both predicted this mess years before it happened. Nothing has changed, toxic assets are STILL accumulating in many funds' portfolios. Who cares? The Guv will bail them out after they're done raping the markets.

give everyone a toilet brush, toilets will get cleaned. give everyone a hammer, nails will get pounded. give everyone a gun, people will get shot

the availability and easy access of a tool with an intended purpose and meaning makes certain outcomes easier. it's not complicated

the tool itself, and the presence of the tool, has significance. we all reach the limits of our temper at various points in our lives. we will confuse our teenage son sneaking into the house in the dark with an intruder. we will be drunk and clumsy. and in those situations, whether or not a gun is in easy reach radically changes the outcome of the situation

the purpose and presence of the tool matters

the proper quote is

"guns don't kill people, people with guns do"

if you want guns to be legal, fine. but don't depend upon flimsy easily dismantled logic to justify your beliefs

In this case, Black-Scholes led to the excess credit by creating too much investor confidence in the loans being given. Because it models risk as a thin-tailed distribution, its use systemically encourages risk taking.

The difference here is how the existence of that excess credit was justified. The model says you can create riskless investment positions, in which case, why not extend more credit? You've got the risk of default covered. As long as not too many people are doing that, you're actually in pretty good shape. When enough people are doing it, you end up with people shoring each other's absolutely safe investments up, a situation ripe for a chain reaction.

Deregulation, not models, permitted bad behavior. Banks that guarantee loans simply should not be emulsifying them into packaged trades, and then hedging their own equity on the loan derivatives. It's like taking a tulip bulb, selling interest in a tenth of the bulb with 1000:1 equity, and then saying it's more stable. Once it goes the wrong way you are screwed and you know it (but you just don't want to believe it could ever happen).

The emulsifying you are talking about wasn't the problem so much as was the leverage and the short information horizon. An investor could buy one mortgage and take on binary risk- it pays off, or it fails. That's a lot of risk. So he can pool his money with a bunch of other people and buy 1% of 100 loans. The risk of any loan failing is spread across all the investors. That, in itself, is a good idea, it is just basic diversification.

The leverage problem was that they didn't just split the loans equally like that, they split the loans into tranches, or classes, of investor. The risk averse investor bought the high quality tranche, and for that got a higher guarantee of payment in exchange for a higher price (lower yield). The lower tranches were sold to suckers with the promise of potentially high rates of return. But as the individual loans started failing, the way the package was levered, the higher investors ended up getting paid, and the lower investors got nothing.

A quick example of the information problem was the practice of the 80-15-5 mortgage loans. Conventional wisdom says that when someone takes out a mortgage with zero down, that mortgage is more likely to fail. So again, conventional wisdom says that in order to hedge for that increased potential failure, you need to charge a higher interest rate. For some reason, and I agree it was probably lack of regulation, someone figured out that you could split the mortgage into three portions- standard risk (the 80%), higher risk (the 15%) and highest risk (the 5%). In the documents for the 80% loan, you could then say that this loan had 20% down, and you'd get the good rate. Then you do the same with the 15% loan- "hey, this loan has 5% down, give us the OK rate". Then you would only end up paying the super high risk rate on 5% of the balance of the mortgage instead of the whole thing. The problem there was that the whole loan had the high risk, but the investors in the 80% and the 15% didn't know it.

Well, you could argue that any bank doing that would just eventually fail due to their policy of underestimating risks. The problem is that the bank gets to take down everyone around them as well. Why are banks so huge and powerful?

Perhaps if banks were treated like normal businesses it wouldn't be such a big deal when they fail. Then again there is a 200 year history of special treatment (bank holidays, etc) so it would be a shock to the system to do that now.

Exactly. The Black-Scholes formula (and most other formulas which attempt to predict market behavior) are structured on the theory that people make decisions regarding buying and selling based on factors primarily concerned with the value of the financial instrument being traded vs the value of other financial instruments that are available to the buyer and seller. The problem with the formula happens when people start to make decisions regarding the market on the basis of the formula rather than their perc

Interesting, but really, blaming the seed on Jack looting the giant's castle? I used to write risk analysis software for the traders and market makers at the options exchange in Chicago (CBOE) and am intimately familiar with Black-Scholes algorithm (I've implemented it more than once). In the article, the sub-text to one photo, "Options allow a trader to have a delicious risk-free portfolio", is totally bogus! Options allow a trader to MINIMIZE the risk in their portfolios, and BS (no pun intended) helps traders to do that in a mathematically/statistically rigorous way. Misuse of any tool (using a hammer to kill someone, for example) is not the tool's fault, but the wielder of the tool!

2. Bundle slices of thousands of these mortgages into derivatives along with "insurance" against the mortgages defaulting and "insurance" against the bundles failing, etc, under the direction of math and finance PhD's [slashdot.org]. Sell these "Triple-A-rated securities" to gullible investors worldwide.

3. ??

4. Profit!

8-figure pay packages for bankers and 7-figure for mortgage brokers, real estate agents, workers in credit rating agencies, etc. until the music stops. But hey, you won't need to defend your resume when you've got enough millions in the bank.

"Whoah, cowboy! "falsifying documents" is fraud. Fraud is a crime. Making a false accusation a crime in writing is libel. Slashdot's policy is that "all comments are owned by the poster." I do hope you got something to back up the "falsifying" claim. Otherwise, some "bankster" or such just might get annoyed enough to go after you.... cause you know... he might have a case."

There are numerous documented cases of fraud. The robo-signing scandal is just a huge, massive fraud. Read any of the crisis books, they

Whoah, cowboy! "falsifying documents" is fraud. Fraud is a crime. Making a false accusation a crime in writing is libel.

I know several people in the compliance area of the Mortgage industry that document everything they do to cover their asses because they seriously suspect that the way the companies they work for are doing things is fraudulent. Of primary concern is having unlicensed loan origination AND processing illegally outsourced to India. The compliance managers tell their higher ups that what they're doing is probably wrong, but they don't care; They're yes men. The bosses are business men making deals trying to m

I highly recommend the opera at http://www.youtube.com/watch?v=JhEH00rlmz8 [youtube.com], from the Ig Nobel prizes a few years ago. It captured the most recent banking crisis rather well, and without the need to blame human greed on misused mathematical formula.

What's worse is that if you base all currencies on the same finite resource, the rich countries corner the market in that resource. If you want to bolster your currency, you have to buy the resource, but nobody is selling. This raises the price of the resource, strengthening the rich country's position and weakening the poor country's position. This actually happened and it led to the abandonment of the gold standard.

I've heard this repeated several times but it's a load of misinformed crap. It's one of those "makes sense to someone who knows nothing but is totally false" myths.

When a central bank creates money through a loan and it is later paid back, it is only the principal of the loan that is created and destroyed. The interest portion is considered the bank's profit and is paid out to the bank's shareholders (whoever that may be, it differs depending on which country you're talking about, but usually member banks and/or the government). That money is not destroyed and re-enters circulation. How would it even make sense for the interest to be destroyed as well?? That would totally break the concept of double-entry accounting (which central banks do still follow).

I don't know where this myth started but it's 100% false. I realise the financial crisis has made everyone interested and out for easy answers, but "the only thing it can possibly end in is debt and the enslavement of entire nations... Exactly as designed"? Please. I hate bankers as much as the next person but i wish we could focus on the real problem (outright, unpunished fraud) rather than this kind of fairytale crap.

The equation was not at fault: the output is only as good as the inputs. The real problem was the instruments being traded: credit default swaps. These are of dubious merit and much more complicated than more traditional underlying instruments (the thing on which you hold an option contract). For example, suppose you have an option to be 100 shares of Google at a given price. It's easy to evaluate the value of the underlying instrument because there's an efficient market for it: Google is traded on a public exchange and the value is agreed upon within a penny, generally. Black-Scholes works on Google options just fine and you can minimize your risk reasonable well using it.

The credit default swaps were much more difficult to evaluate because of the lack of an efficient market for them. The essential nature of the underlying instrument were very high risk mortgages, not too different in concept from so-called junk bonds. The potential return was high because the interest rate was high. The potential risk was high because the risk of default was high, making the underlying instrument worth very little, much less than face value. So take these risky mortgages and then buy insurance policies for them, this is standard practice. That hedges the risk of the actual mortgage itself. Bundle the mortgage and the insurance policy up into a quasi-mutual fund like product: you have x number of mortgage/insurance policy bundles with average risk of default at y. Getting more difficult to put a value on, especially since there is no regulated exchange for them and little oversight.

Not done yet. Add in that deregulation rules passed during the Clinton era allowed the banks that issue the mortgages and buy the insurance policies to also use their assets to trade on their own. This group within a group is called "proprietary trading". So, the prop-trading groups within the banks buy and sell the mortgages and insurance policies to each other in order to generate income for the bank. There are also other groups that buy and sell these instruments that don't actually issue mortgages. These are called speculative traders.

Finally, to put the finishing touches on this pile of doo, have a group create a new instrument: a binary option (it does or it doesn't) on a bundle of high-risk mortgages and their insurance policies. A binary option is essentially a gamble: it pays out if something happens, it does not pay out if something doesn't happen. Now you're buying and selling options contracts which predict whether a group of mortgages will fail or not. There's no regulation, no formal exchange (which helps create market efficiency). There's no reliable way to determine the value of the underlying instrument because it depends on knowing how many of the mortgages will fail. And don't forget that the banks were using their investment customers to create demand for a product they wanted to sell ("I think you should invest in such-and-such") without telling the customers that the banks themselves would be profiting by selling questionable instruments to their own customers.

This is the magic of unregulated capitalism (almost - the banks should have been allowed to fail in a purely unregulated capitalism system). Nothing wrong with Black-Scholes here. The real problem at the core is that the banks involved are so driven by short-term success that there is no room for sanity. Wrap it all up with the fact that the banks know they will be bailed out by the Feds if they fail. There is no penalty for risk and no regulatory oversight. Gotta have one or the other or we just plain deserve this insanity.

I don't read a lot in my spare time, but one author I like is William Poundstone. I was going on an international trip and I wanted a book to take with me to read to kill time, so I bought his book _Fortune's Formula_. Essentially the book is about some Bell Labs geniuses who came up with mathematical models that allowed them first to make money at casinos and then to exploit weaknesses in the US stock market to make money. Scholes is featured in the book, but he's not a main character. I offer the following 2 quotes directly from the book which are on this very subject.

"LTCM was simply in the position of a gambler who goes to a casino where the pit boss gives him unlimited credit." (page 283) Note that LTCM was the fund that Scholes helped run. The book further goes on to state that in real life, nobody gets truly "unlimited credit". A casino will not loan more money than they can collect. But LTCM's business model depended on credit never running out to them.

"Warren Buffet marveled at how 'ten or 15 guys with an average IQ of maybe 170' could get themselves 'into a position where they can lose all their money.'" (page 291) It's a big simplification, but basically LTCM got burned by the Russian currency collapse which started a chain of events that killed them.

BS had zero to do with any of the problems which led to the various market meltdowns. What did? Ignorance of liquidity (more precisely, lack of liquidity), counterparty risk, seriously flawed assumptions about various correlations (think gdp, unemployment, geography, subprime mortgages), significant excess leverage financed at exceptionally low interest rates, creation of intstruments which allowed some holders to game the system (credit default swaps) and lastly, ignorance and greed. There are, of course, myriad other contributors but BS is not one of them.

Disclaimer: besides having a masters degree in computational finance I worked in the industry for nearly two decades.

myron scholes or any of the other tools that enabled the 2008 crash, including CDOs, securitization, etc.

Edwrd Chancellor has a much, much more accurate , and scientific approach to crises - and that is to catalog and record them and their details, going back to Tulipmania and before. His book "Devil take the hindmost" came out before the 2008 crash, but basically what he is doing is proving that History is much more of a 'science' than economics --- at least in History, they try to gather actual data before making theories, and throw out the theories when the facts dont match.

the various attempts to 'blame math' for the crash of 2008 are little more than attempts to cover up the massive fraud that was perpetrated on the taxpayers of the planet. you make a huge amount of horrible loans to people you know cannot pay them back, resell the loans to people and lie about it, then get the government to bail you out when the whole system is about to collapse. you dont need a formula to do that, it is the basic feature of every economic bubble and its bursting. Fraud.

the difference here is that the fraudsters have completely made an end run around all the rules implemented after the 1929 crash to prevent this sort of thing, they practically own the politicians that are supposed to regulate them, and they insinuate themselves into positions of power in the political class. thats the difference - that we are actually regressing backwards in our civilization, and having the free market run less well than it did previously, and watching entrepenurial capitalism die a nasty death by its own supposed proponents.

Black-Scholes is sound in a statistical/mathematical sense. Unfortunately it makes implicit assumptions about how the market operates that simply aren't true, so it was bound to fail. Financial engineers -- and I use the word "engineers" loosely here! -- accepted the assumptions as gospel because their jobs/bonuses depended on it.

I used to work in that industry. It will be a cold day in Hell before I go back.

The only way to prevent another train wreck is to remove the incentives for "too big to fail" banks to take unreasonable risks with other peoples' money, based on the assumption that the government will bail them out if things go badly.

Actually reading through the BBC story, I feel it's yet another example of the BBC's declining grasp of anything technical. Long term capital management called into question Black-Scholes and demonstrated extreme events in markets, sure. But the elements of the recent crash were also to do with greed, arrogance, mis-selling [of mortgages that were then securitised in un-auditable and therefore un-priceable mixtures] bad-fatih [banks selling both complex derivatives AND insurance for the failure of these complex derivatives] and a general credit-bubble that distorted asset pricing. Michael Lewis' the Big Short: http://www.amazon.com/The-Big-Short-Doomsday-Machine/dp/0393072231 [amazon.com] is very good on the detail of this.

Then, because the firewalls between speculation and retail banking had been removed, there was a great deal of general contagion and bank to bank movements froze.

However, one can't conclude that all mathematical pricing is wrong from these two separate events. One can reach conclusions regulation, capital adequacy, firewalls etc/ Above all, if the public is well protected and genuine industry is well protected, these idiots [of which I was one once] can do what they like and then suffer the consequences.

Actually, the Black-Scholes formula is innocent. Sure, it assumes that stock movements follow a standard distribution, but that's not as big a sin as is being made out in the article. The formula computes the fair price for an option contract. Such a contract gives its owner the right (or "option") to buy or sell some asset up to a future date (the expiry date), at some given price (the "strike" price). The formula uses the following values:

1. The time remaining until the contract expires
2. The current price of the undelying asset
3. The strike price (the contract gives its buyer the right or "option" to buy the asset at the strike price)
4. The risk-free rate of return on cash (return that could be earned by putting your money into, say, treasuries rather than stock)
5. The volatility of the underlying asset.

At the time the contract is written, the first four of these values are known (assuming of course that the risk-free rate stays constant, which is pretty close to a sure bet). The LAST value is the problem. It says how much the stock will fluctuate, between the present time and the time of expiry. This is unknown, because, after all, it requires knowledge of the future. Usually, PAST volatility is used in its place, going with the assumption that the stock will behave in the future the same way it behaved in the recent past.

If the stock suddenly becomes very quiet, and stops fluctuating, the buyer payed too much for the contract, on average. If the stock gets very wild, the buyer got a bargain, on average. In either case, the contract buyer and seller guessed wrong. They should have used a different volatility to price the option.

Of course, stock fluctuations do NOT follow a normal curve, after all. And option traders do NOT follow Black-Scholes exactly either (see "volatility smile"). But the much bigger flaw, I think, is lack of clairvoyance. The formula requires knowledge of the future.

The Black-Scholes model is an attempt to apply solved heat flow equations to a financial pricing problem.
It requires demonstrably invalid assumptions to be made to make it work (such as markets do not trend).
Just because a Nobel prize was awarded does not make the model valid.

The same can be said for pretty much advance in science in the last 50 years. If you're truly interested in what can and cannot be predicted - given correct models, there's a science studying that, complexity theory.

But from finance over climate to even whether the planets will keep turning - all are too complex to be predicted, even though science has advanced to the point where individual events can be predicted short times in advance with near-certainty. However there's obvious things that can't be predicted. If the moon decides to crash into the earth, we will know in advance - but only a few weeks at the most. Yes, really.

In some ways this was inevitable. Science has moved from predicting individual events, like say a car collision, or physical changes happening inside an extremely well-described cloud, a single rational decision taken by someone considering a bank loan - to predicting the global effects of an undefined number of such interactions combined. The answer coming out of all this is rather disappointing : it's not working - and it isn't working any better outside of finance either. The mathematician's answer, chaos theory, is thoroughly disappointing : there is no valid way to make useful long-term predictions of any system more complex than X (btw: you want a nobel prize ? find what X is exactly) which does not require omniscience (which for any real world prediction would effectively be all the information that exists anywhere in the universe)

So the real question changes - if you require proof we can essentially predict nothing. If you even require valid inputs to statistical functions we can essentially predict nothing. Barely any recent science follows from first principles, except perhaps in Mathematics. Physics makes a good-hearted attempt, but it has to violate the first-principles - it's attempting to discover new ones. Every other science never even attempts to work from first principles, it just doesn't work.

Finance - the models only work when you assume decisions don't interact in the short term (ie. nobody decides to either sell a house or forestall selling it because of anything that happens that doesn't directly affect that loan. If this is true, then the financial crisis was impossible (yet also inevitable)). And of course the basic economic assumption - that everyone takes the rational course of action immediately - no matter how complex the logic, and irrespective of any personal convictions.Climate - energy balance only has to sum up if you assume the entropy of the system is negligible, or if you work on infinite time-scales. Needless to say, infinite time scales are a bit long for practical usage. Entropy within our atmosphere is anything but negligible. The second big assumption made in climate science is that small portions of the atmosphere behave identical to large portions of the atmosphere.Planets - planet's orbits only behave the way you're taught in school if they followed Newton. But that's not the worst assumption. The other assumption necessary to make Kepler work is that planetary orbits are independent, and no objects with mass can possibly cross into orbits (and obviously that orbits don't cross)

All these assumptions can be proven to be wrong - and rather trivially.

In one case this can be shown. Planetary orbits are extremely, extremely regular in the short term. This was useful for sea-faring when it was discovered as it provided a very accurate source of timing. And we still have the books from those days describing how those measurements worked. We still have books describing how to find a ship's position on earth by measuring the orbits of Jupiter's moons... only they yield incorrect results. You might chalk that up to bad measurements, but that can't be : if the methods were truly useless, they would never have been written down. Plus we can correct the measurements so they work again. No, the reason is much simpler : Jupiter's moons have shifted so much over the course of 300 years that those me

The same can be said for pretty much advance in science in the last 50 years. If you're truly interested in what can and cannot be predicted - given correct models, there's a science studying that, complexity theory.

There is more to science than messing with statistics in artificial environments.

Climate models are based on thermodynamics and don't ignore entropy; they're not all simple energy balance models. It is true, however, that not as much attention is given to the numerics of correctly tracking entropy as to other aspects of the numerics.

Likewise, climate models are based on fluid dynamics but don't assume all scales are the same; see sub-grid scale parameterizations (e.g., of turbulent ocean eddies in models that are too coarse to resolve them).

There's more to it than that. The model has developed into a philosophy which has been built out beyond its workable foundation.

It starts with the risk neutral measure. Basically the concept is that you can construct a probability measure (basically a reweighting of probability of events) from market prices. Basically the market prices of a stock, a forward contract (a contract to deliver the stock at a fixed point in the future), a call option (an agreement to offer the option of buying the stock at a given price in the future), a put option (an agreement to offer the option to sell a stock at a given price in the future), and other contracts related to the price of the stock in the future all have to have prices rationally related to each other. If the price of one of these things deviates from the risk neutral measure implied by the others, you can construct arbitrage positions where you can make a profit with negligible risk and executing this arbitrage has the effect of moving the market prices closer toward their theoretical values.

Observably, market prices don't reflect real probabilities. Safe investments such as treasury bonds are disproportionately more expensive than highly rated bonds with a low chance of default based on historical default rates. This is explained due to risk aversion and philosophically, the risk neutral measure is said to reflect the market's assessment of the risk of each investment and also the risk preferences of market participants. This concept is the basis of financial economics, and the school of thought derived from this position has been dominant in economic related disciplines for the past 30 years.

As a means of analyzing for arbitrage opportunities and pricing of marketable securities in a way that avoids offering others arbitrage opportunities, this methodology is largely unassailable. However, where they overextend themselves is that in conjunction with the efficient market hypothesis, they've started to assume that this framework lets you farm out the function of assessing the likelihood of future events to the market and even in some cases they've asserted that it's immoral to use methodologies which imply prices for non-marketable securities which aren't directly comparable to marketable analogues.

It's basically a religion at this point. They honestly believe that the risk neutral measure isn't just a post hoc rationalization imposed on market prices, but a normative guide to upright living and that the market's assessments of the ("risk-adjusted") probability of future events is the best and most rational basis for making all decisions and for framing all policy and regulation.

I agree that this is a big deal, but it's not the entire problem. As I noted, these models don't deal with real probabilities, they're a framework for dealing with market implied probabilities in such a way that arbitrages can be constructed that pay out regardless of the outcomes. It's actually a framework for constructing portfolios that are independent of future outcomes, not one that actually predicts them, although the distinction is lost on a lot of people.

the thing about the LTCM is that the guys that ran it got jobs in the industry, again, and they proceeded to destroy even more money, and then they did it again and again and again.

people say that capitalism 'weeds out the non performers' but when you look at the history of places like LTCM, its bullshit. its a big old boy network where people like Dick Fuld do not get busted down to street sweeper - they get to sit on millions of dollars of other peoples money, forever, with no prosecution of any kind. guy